Successfully managing a business goes beyond understanding cash, profit, and sales – it requires financial ratio analysis and interpretation.
The business world is full of financial data and metrics, which are vital factors for boosting growth in any company. However, you’d do well to recognize the values in your financial reports are more than just numbers.
Successful businesses have learned how to gauge and interpret their data effectively. But because they generally have little historical data, startups might have difficulty forming conclusions from raw data.
Financial metrics are crucial for driving operational improvements. But how can you turn raw data into valuable insight?
The answer is through financial ratios.
Explaining Financial Ratios
In simple terms, financial ratios are the relationships of data in the company’s financial reports. Their purpose is to compare data to make meaningful financial information.
Ratios occur when dividing one variable by another and are often converted to percentages. You can analyze these ratios to gather information:
- About the company’s finances
- To measure internal progress
- To compare to other businesses in the industry
In other words, financial ratio analysis is a powerful analytical tool to measure your company’s financial health.
Analysts and business owners use many different ratios to assess the financial status of a company.
Types of Financial Ratios
Every business owner must assess and understand various key financial indicators. Here are the types of financial ratios you must know:
Profitability ratios
Profitability ratios show the performance of the business in terms of profit vs.:
- Sales
- Cost of Goods Sold (COGS)
- Operating Expenses
Several factors can affect your profitability ratios. Changes to prices, sales volumes, and expenses all move your profitability up or down.
Liquidity ratios
These financial ratios show the company’s ability to cover short-term obligations. Moreover, liquidity ratios compare liquid assets like cash and short-term receivables versus short-term debts. To determine the liquidity ratio, managers or business owners look at:
- Working capital ratio
- Cash ratio
- Quick ratio
Debt ratios
The debt ratio measures the solvency of a business compared with the level of debt financing to fund its operations. It consists of:
- Total debt ratio
- Debt to equity ratio
The total debt ratio measures total debts versus total assets and gauges the portion of your capital obtained through debt. It is different from the debt to equity ratio, as the latter focuses on the relative mix of debt and equity used to finance assets.
Operating performance ratios
Business owners can use these ratios to measure how efficiently the company is utilizing resources to:
- Generate profit.
- Convert assets to cash.
Operating performance ratios might focus on the fixed asset turnover or revenue per employee. These, of course, are rarely shown as percentages.
Essential Financial Ratios to Track
Analysts, investors, and business owners use multiple financial ratios to measure a company’s financial stability. For startups, the following are essential ratios to be evaluated and observed:
Debt to capital ratio
The debt to capital ratio is another measure of financial leverage. Divide the sum of the company’s interest-bearing short-term and long-term debts by the total capital.
This financial ratio gives you an idea of whether your company’s economic structure is suitable for an outside investor. A higher debt to capital ratio means your company is a risky investment.
Profit margin
Profit margin is a profitability ratio showing the profit per dollar sales by dividing net income by sales.
Profit margin can indicate how well a company manages its finances. However, it might also show that current costs and revenues don’t align. This misalignment is especially true for growing companies.
Quick ratio
The quick ratio, or the acid test ratio, is a type of liquidity ratio, and it considers current assets less inventory divided by the current liabilities. Essentially, this ratio determines if the company can cover its short-term obligations without selling inventories.
Customer churn rate
The customer churn rate refers to the percentage of customers who stop doing business with your company each month.
Debt to equity ratio
As previously indicated, the debt to equity ratio measures the company’s mix of debt and equity. This mix is essential for a publicly-traded company as it focuses on the value of outstanding shares vs. the level of debt.
Sales per employee
This financial ratio measures the efficiency and efficacy of a company’s workforce. To calculate, divide the annual sales by its total employees.
Using Financial Ratios for Business Growth
Developing an understanding of these financial ratios is essential for driving business growth.
When you know what you’re tracking and how to influence the metrics, your ability to steer the business will improve.
Financial ratios give you an idea of where your business stands. When a ratio isn’t meeting the target, you’ll know it’s time to make adjustments.
Want a Better Understanding of How Financial Ratios Play a Role in Your Business?
Financial ratios are an essential tool for measuring business progress and keeping track of your financial goals.
Regularly performing financial ratio analysis will help you see and understand the trends affecting your operations. With these key metrics, you can make better decisions for your business.
However, correctly interpreting these ratios requires sufficient knowledge about financial metrics. Incorrect interpretation of your company’s financial reports may lead to bad decisions or worse.
While information is critical, numbers without action are useless.
Here at Founder’s CPA, our team has the competitive skills to help you better interpret your business’s finances. If you’re ready to level up your business, contact us now to set up a complimentary assessment.
